April 2005 INCOME INEQUALITY IN THE UNITED STATES, 1913-2002* THOMAS PIKETTY, EHESS, Paris EMMANUEL SAEZ, UC Berkeley and NBER This paper presents new homogeneous series on top shares of income and wages from 1913 to 2002 in the United States using individual tax returns data. Top income and wages shares display a U-shaped pattern over the century. Our series suggest that the large shocks that capital owners experienced during the Great Depression and World War II have had a permanent effect on top capital incomes. We argue that steep progressive income and estate taxation may have prevented large fortunes from fully recovering from these shocks. Top wage shares were flat before World War II, dropped precipitously during the war, and did not start to recover before the late 1960s but are now higher than before World War II. As a result, the working rich have replaced the rentiers at the top of the income distribution. We emphasize the role of social norms as a potential explanation for the pattern of wage shares. *This paper is a longer and updated version of Piketty and Saez (2003). We thank Tony Atkinson for very helpful and detailed comments. We thankfully acknowledge financial support from the McArthur Foundation, the Alfred P. Sloan Foundation, and NSF Grant SES-0134946.
1 1. INTRODUCTION According to Kuznets influential hypothesis, income inequality should follow an inverse-u shape along the development process, first rising with industrialization and then declining, as more and more workers join the highproductivity sectors of the economy [Kuznets 1955]. Today, the Kuznets curve is widely held to have doubled back on itself, especially in the United States, with the period of falling inequality observed during the first half of the 20 th century being succeeded by a very sharp reversal of the trend since the 1970s. This does not imply however that Kuznets hypothesis is no longer of interest. One could indeed argue that what has been happening since the 1970s is just a remake of the previous inverse-u curve: a new industrial revolution has taken place, thereby leading to increasing inequality, and inequality will decline again at some point, as more and more workers benefit from the new innovations. To cast light on this central issue, we build new homogeneous series on top shares of pre-tax income and wages in the United States covering the 1913 to 2002 period. These new series are based primarily on tax returns data published annually by the Internal Revenue Service (IRS) since the income tax was instituted in 1913, as well as on the large micro-files of tax returns released by the IRS since 1960. First, we have constructed annual series of shares of total income accruing to various upper income groups fractiles within the top decile of the income distribution. For each of these fractiles, we also present the shares of each source of income such as wages, business income, and capital income. Kuznets [1953] did produce a number of top income shares series covering the 1913 to 1948 period, but tended to underestimate top income shares, and the highest group analyzed by Kuznets is the top percentile. 1 Most importantly, nobody has attempted to estimate, as we do here, homogeneous series covering 1 Analyzing smaller groups within the top percentile is critical because capital income is extremely concentrated.
2 the entire century. 2 Second, we have constructed annual 1927 to 2002 series of top shares of salaries for the top fractiles of the wage income distribution, based on tax returns tabulations by size of salaries compiled by the IRS since 1927. To our knowledge, this is the first time that a homogeneous annual series of top wage shares starting before the 1950s for the United States has been produced. 3 Our estimated top shares series display a U-shaped over the century and suggest that a pure Kuznets mechanism cannot account fully for the facts. We find that top capital incomes were severely hit by major shocks in the first part of the century. The post World War I depression and the Great Depression destroyed many businesses and thus reduced significantly top capital incomes. The wars generated large fiscal shocks, especially in the corporate sector that mechanically reduced distributions to stockholders. We argue that top capital incomes were never able to fully recover from these shocks, probably because of the dynamic effects of progressive taxation on capital accumulation and wealth inequality. We also show that top wage shares were flat from the 1920s until 1940 and dropped precipitously during the war. Top wage shares have started to recover from the World War II shock in the late 1960s, and they are now higher than before World War II. Thus the increase in top income shares in the last three decades is the direct consequence of the surge in top wages. As a result, the composition of income in the top income groups has shifted dramatically over the century: the working rich have now replaced the coupon-clipping rentiers. We argue that both the downturn and the upturn of top wage shares seem too sudden to be accounted for by technical change alone. Our series suggest that other factors, such as changes in labor market institutions, fiscal policy, or more generally social norms regarding pay inequality may have played important roles in the determination of the wage structure. Although our proposed interpretation for the observed trends seems plausible to us, we stress that we cannot prove 2 Feenberg and Poterba [1993, 2000] have constructed top income share series covering the 1951-1995 period, but their series are not homogeneous with those of Kuznets. Moreover, they provide income shares series only for the top 0.5 percent, and not for other fractiles. 3 Previous studies on wage inequality before 1945 in the United States rely mostly on occupational pay ratios [Williamson and Lindert 1980, Goldin and Margo 1992, and Goldin and Katz 1999].
3 that progressive taxation and social norms have indeed played the role we attribute to them. In our view, the primary contribution of this paper is to provide new series on income and wage inequality. One additional motivation for constructing long series is to be able to separate the trends in inequality that are the consequence of real economic change from those that are due to fiscal manipulation. The issue of fiscal manipulation has recently received much attention. Studies analyzing the effects of the Tax Reform Act of 1986 (TRA86) have emphasized that a large part of the response observable in tax returns was due to income shifting between the corporate sector and the individual sector [Slemrod 1996, Gordon and Slemrod 2000]. We do not deny that fiscal manipulation can have substantial short-run effects, but we argue that most long-run inequality trends are the consequence of real economic change, and that a short-run perspective might lead to attribute improperly some of these trends to fiscal manipulation. The paper is organized as follows. Section II describes our data sources and outlines our estimation methods. In Section III, we present and analyze the trends in top income shares, with particular attention to the issue of top capital incomes. Section IV focuses on trends in top wages shares. Section V offers concluding comments and proposes an international comparison. All series and complete technical details about our methodology are gathered in the appendices of the paper. 2. DATA AND METHODOLOGY Our estimations rely on tax returns statistics compiled annually by the Internal Revenue Service since the beginning of the modern U.S. income tax in 1913. Before 1944, because of large exemptions levels, only a small fraction of individuals had to file tax returns and therefore, by necessity, we must restrict our analysis to the top decile of the income distribution. 4 Because our data are based on tax returns, they do not provide information on the distribution of individual
4 incomes within a tax unit. As a result, all our series are for tax units and not individuals. 5 A tax unit is defined as a married couple living together (with dependents) or a single adult (with dependents), as in the current tax law. The average number of individuals per tax unit decreased over the century but this decrease was roughly uniform across income groups. Therefore, if income were evenly allocated to individuals within tax units, 6 the time series pattern of top shares based on individuals should be very similar to that based on tax units. Tax units within the top decile form a very heterogeneous group, from the high middle class families deriving most of their income from wages to the superrich living off large fortunes. More precisely, we will see that the composition of income varies substantially by income level within the top decile. Therefore, it is critical to divide the top decile into smaller fractiles. Following Piketty [2001a, 2001b], in addition to the top decile (denoted by P90-100), we have constructed series for a number of higher fractiles within the top decile: the top 5 percent (P95-100), the top 1 percent (P99-100), the top 0.5 percent (P99.5-100), the top 0.1 percent (P99.9-100), and the top 0.01 percent (P99.99-100). This also allows us to analyze the five intermediate fractiles within the top decile: P90-95, P95-99, P99-99.5, P99.5-99.9, P99.9-99.99. Each fractile is defined relative to the total number of potential tax units in the entire U.S. population. This number is computed using population and family census statistics [U.S. Department of Commerce, Bureau of Census 1975 and Bureau of Census 1999] and should not be confused with the actual number of tax returns filed. In order to get a more concrete sense of size of income by fractiles, Table I displays the thresholds, the average income level in each fractile, along with the number of tax units in each fractile all for 2000. 4 From 1913 to 1916, because of higher exemption levels, we can only provide estimates within the top percentile. 5 Kuznets [1953] decided nevertheless to estimate series based on individuals not tax units. We explain in Piketty and Saez [2001] why his method produced a downward bias in the levels (though not in the pattern) of top shares. 6 Obviously, income is not earned evenly across individuals within tax units, and, because of increasing female labor force participation, the share of income earned by the primary earner has certainly declined over the century. Therefore, inequality series based on income earned at the individual level would be different. Our tax returns statistics are mute on this issue. We come back to that point when we present our wage estimates.
taxes. 8 The sources from which we obtained our data consist in tables displaying 5 We use a gross income definition including all income items reported on tax returns and before all deductions: salaries and wages, small business and farm income, partnership and fiduciary income, dividends, interest, rents, royalties, and other small items reported as other income. Realized capital gains are not an annual flow of income (in general, capital gains are realized by individuals in a lumpy way) and form a very volatile component of income with large aggregate variations from year to year depending on stock price variations. Therefore, we focus mainly on series that exclude capital gains. 7 Income, according to our definition, is computed before individual income taxes and individual payroll taxes but after employers payroll taxes and corporate income the number of tax returns, the amounts reported, and the income composition, for a large number of income brackets [U.S. Treasury Department, Internal Revenue Service, 1916-2002]. As the top tail of the income distribution is very well approximated by a Pareto distribution, we use simple parametric interpolation methods to estimate the thresholds and average income levels for each of our fractiles. We then estimate shares of income by dividing the income amounts accruing to each fractiles by total personal income computed from National Income Accounts [Kuznets, 1941, 1945, and U.S. Department of Commerce, 2000]. 9 Using the published information on composition of income by brackets and a simple linear interpolation method, we decompose the amount of income for each fractile into five components: salaries and wages, dividends, interest income, rents and royalties, and business income. 7 In order to assess the sensitivity of our results to the treatment of capital gains, we present additional series including capital gains (see below). Details on the methodology and complete series are presented in appendix of Piketty and Saez [2001]. 8 Computing series after individual income taxes is beyond the scope of the present paper but is a necessary step to analyze the redistributive power of the income tax over time, as well as behavioral responses to individual income taxation. 9 This methodology using tax returns to compute the level of top incomes, and using national accounts to compute the total income denominator is standard in historical studies of income inequality. Kuznets [1953], for instance, adopted this method.
6 We use the same methodology to compute top wage shares using published tables classifying tax returns by size of salaries and wages. In this case, fractiles are defined relative to the total number of tax units with positive wages and salaries estimated as the number of part-time and full workers from National Income Accounts [U.S. Department of Commerce, 2000] less the number of wives who are employees [estimated from U.S. Department of Commerce, Bureau of Census 1975 and Bureau of Census 1999]. The sum of total wages in the economy used to compute shares is also obtained from National Income Accounts [U.S. Department of Commerce, 2000]. The published IRS data vary from year to year and there are numerous changes in tax law between 1913 and 2002. 10 To construct homogeneous series, we make a number of adjustments and corrections. Individual tax returns microfiles are available since 1960. 11 They allow us to do exact computations of all our statistics for that period and to check the validity of our adjustments. Kuznets [1953] was not able to use micro-files to assess possible biases in his estimates due to his methodological assumptions. 12 Our method differs from the recent important studies by Feenberg and Poterba [1993, 2000] who derive series of the income share of the top 0.5 percent 13 for 1951 to 1995. They use total income reported on tax returns as their denominator and the total adult population as their base to obtain the number of tax units corresponding to the top fractiles. 14 Their method is simpler than ours but cannot be used for years before 1945 when a small fraction of the population filed tax returns. 10 The most important example is the treatment of capital gains and the percentage of these gains that are included in the statistics tables. 11 These data are known as the Individual Tax Model files. They contain about 100,000 returns per year and largely oversample high incomes, providing a very precise picture of top reported incomes. 12 In particular Kuznets treatment of capital gains produces a downward bias in the level of his top shares. 13 They also present incomplete series for the top 1percent. 14 This method is not fully satisfying for a long-run study as the average number of adults per tax unit has decreased significantly since World War II.
7 3. TOP INCOME SHARES AND COMPOSITION A. Trends in Top Income Shares The basic series of top income shares are presented in Table A1. Figure I shows that the income share of the top decile of tax units from 1917 to 2002 is U- shaped. The share of the top decile fluctuated around 40 to 45 percent during the interwar period. It declined substantially to about 30 percent during World War II, and then remained stable at 31 to 32 percent until the 1970s when it increased again. By the mid-1990s, the share had crossed the 40 percent level and is now at a level close to the prewar level, although a bit lower. Therefore, the evidence suggests that the twentieth century decline in inequality took place in a very specific and brief time interval. Such an abrupt decline cannot easily be reconciled with a Kuznets type process. The smooth increase in inequality in the last three decades is more consistent with slow underlying changes in the demand and supply of factors, even though it should be noted that a significant part of the gain is concentrated in 1987 and 1988 just after the Tax Reform Act of 1986 which sharply cut the top marginal income tax rates (we will return to this issue). Looking at the bottom fractiles within the top decile (P90-95 and P95-99) in Figure II reveals new evidence. These fractiles account for a relatively small fraction of the total fluctuation of the top decile income share. The drop in the shares of fractiles P90-95 and P95-99 during World War II is less extreme than for the top decile as a whole, and they start recovering from the World War II shock directly after the war. These shares do not increase much during the 1980s and 1990s (the P90-95 share was fairly stable, and the P95-99 share increased by about 2 percentage points while the top decile share increased by about 10 percentage points). In contrast to P90-95 and P95-99, the top percentile (P99-100 in Figure II) underwent enormous fluctuations over the twentieth century. The share of total income received by the top 1 percent was about 18 percent before World War I,
8 but only about 8 percent from the late 1950s to the 1970s. The top percentile share declined during World War I and the post war depression (1916 to 1920), recovered during the 1920s boom, and declined again during the Great Depression (1929 to 1932, and 1936 to 1938) and World War II. This highly specific timing for the pattern of top incomes, composed primarily of capital income (see below), strongly suggests that shocks to capital owners between 1914 and 1945 (depression and wars) played a key role. The depressions of the inter-war period were far more profound in their effects than the post-world War II recessions. As a result, it is not surprising that the fluctuations in top shares were far wider during the inter-war period than in the decades after the war. 15 Figure II shows that the fluctuation of shares for P90-95 and P95-99 is exactly opposite to the fluctuation for P99-100 over the business cycle from 1917 to 1939. As shown below, the P90-95 and P95-99 incomes are mostly composed of wage income while the P99-100 incomes are mostly composed of capital income. During the large downturns of the inter-war period, capital income sharply fell while wages (especially for those near the top), which are generally rigid nominally, improved in relative terms. On the other hand, during the booms (1923-1929) and the recovery (1933-1936), capital income increased quickly, but as prices rose, top wages lost in relative terms. 16 The negative effect of the wars on top incomes is due in part to the large tax increases enacted to finance them. During both wars, the corporate income tax (as well as the individual income tax) was drastically increased and this reduced mechanically the distributions to stockholders. 17 National Income Accounts show that during World War II, corporate profits surged, but dividend distributions stagnated mostly because of the increase in the corporate tax (who 15 The fact that top shares are very smooth after 1945 and bumpy before is therefore not an artifact of an increase in the accuracy of the data (in fact, the data is more detailed before World War II than after), but reflects real changes in the economic conditions. 16 Piketty [2001a, 2003] shows that exactly the same phenomenon is taking place in France at the same period. 17 During World War I, top income tax rates reached modern levels above 60 percent in less than two years. As was forcefully argued at that time by Mellon [1924], it is conceivable that large incomes found temporary ways to avoid taxation at a time where the administration of the Internal Revenue Service was still in its infancy.
9 increased from less than 20 percent to over 50 percent) but also because retained earnings increased sharply. 18 The decline in top incomes during the first part of the century is even more pronounced for higher fractiles within the top percentile, groups that could be expected to rely more heavily on capital income. As depicted in Figure III, the income share of the top 0.01 percent underwent huge fluctuations during the century. In 1915, the top 0.01 percent earned 400 times more than the average; in 1970, the average top 0.01 percent income was only 50 times the average; in 2002, they earned about 300 times the average income. Our long-term series place the TRA 1986 episode in a longer term perspective. Feenberg and Poterba [1993, 2000], looking at the top 0.5 percent income shares series ending in 1992 (and 1995 respectively), argued that the surge after TRA86 appeared permanent. However, completing the series up to 2002 shows that the significant increase in the top marginal tax rate, from 31 to 39.6 percent, enacted in 1993 on did not prevent top shares from increasing sharply up to year 2000. 19 From that perspective, looking at Figures II and III, the average increase in top shares from 1985 to 1994 is not significantly higher than the increase from 1994 to 2000 or from 1978 to 1984. As a result, it is possible to argue that TRA86 produced no permanent surge in top income shares, but only a transitory blip. The analysis of top wage shares in Section IV will reinforce this interpretation. In any case, the pattern of top income shares cannot be explained fully by the pattern of top income tax rates. Saez (2004) analyses in much more detail the links between top income shares and marginal tax rates for the period 1960-2000. The drop in top incomes shares from 2000 to 2002, concentrated exclusively among the top 1% is also remarkable. This later phenomenon is likely due to the stock-market crash which reduced dramatically the value of stock- 18 Computing top shares for incomes before corporate taxes by imputing corporate profits corresponding to dividends received is an important task left for future research (see Goldsmith et al. [1954] and Cartter [1954] for such an attempt around the World War II period). 19 Slemrod and Bakija [2000] pointed out that top incomes have surged in recent years. They note that tax payments by taxpayers with AGI above $200,000 increased significantly from 1995 to 1997.
10 options and hence depressed top reported wages and salaries. 20 The series including realized capital gains display an even larger fall (see Figure A2 in appendix). B. The secular decline of top capital incomes To demonstrate more conclusively that shocks to capital income were responsible for the large decline of top shares in the first part of the century, we look at the composition of income within the top fractiles. Table A7 reports the composition of income in top groups for various years from 1916 and 1999. Figure V displays the composition of income for each fractile in 1929 (Panel A) and 1999 (Panel B). As expected, Panel A shows the share of wage income is a declining function of income and that the share of capital income (dividends, interest, rents and royalties) is an increasing function of income. The share of entrepreneurial income (self-employment, small businesses, and partnerships) is fairly flat. Thus, individuals in fractiles P90-95 and P95-99 rely mostly on labor income (capital income is less than 25 percent for these groups) while individuals in the top percentile derive most of their income in the form of capital income. Complete series in Piketty and Saez [2001] show that the sharply increasing pattern of capital income is entirely due to dividends. This evidence confirms that the very large decrease of top incomes observed during the 1914 to 1945 period was to a large extent a capital income phenomenon. One might also be tempted to interpret the large upturn in top income shares observed since the 1970s as a revival of very high capital incomes, but this is not the case. As shown in Panel B, the income composition pattern has changed drastically between 1929 and 1999. In 1999, the share of wage income has increased significantly for all top groups. Even at the very top, wage income and entrepreneurial income form the vast majority of income. The share of capital 20 Because stock-options are reported as wage income only when exercised, our income measure (even excluding capital gains) is contaminated by stock-market fluctuations in the recent decades. Ideally, one would want to include in wage income only the Black-Scholes value of stock-options at the moment they are granted. The difference between the exercise profit and the Black-Scholes value (which is zero in expectation) should be conceptually considered as a capital gain.
11 income remains small (less than 25%) even for the highest incomes. Therefore, the composition of high incomes at the end of the century is very different from those earlier in the century. Before World War II, the richest americans were overwhelmingly rentiers deriving most of their income from wealth holdings (mainly in the form of dividends). Occupation data by income bracket were published by the IRS in 1916 only. Those statistics classified tax returns into 36 different occupations by brackets of income. We have combined these 36 occupations into four groups: salaried professions; independent professions; business owners; and capitalists and rentiers. The salaried professions are those who receive salaries such as teachers, civil servants, engineers, corporation managers and officials. These individuals presumably derive an important part of their income in the form of wages and salaries. Independent professions are self-employed individuals or individuals working in partnerships such as lawyers, doctors, etc. Business owners are merchants, hotel proprietors, manufacturers, etc. These two groups presumably derive most of their incomes in the form of business income. Finally capitalists and rentiers are bankers, brokers, and those who classify themselves as capitalists: investors and speculators, 21 and presumably derive most of their income in the form of capital income. It is possible, especially at the very top, for some individuals to be classified in more than one group. We present in Table 2 the distribution of these four occupation groups by fractiles within the top percentile. 22 This table confirms our previous results: the share of the salaried occupation declines steadily within the top percentile from 28% to less than 10% at the very top. The share of independent professions also declines from 20% to 5%. The share of business owners is first increasing (from 30% to 40%) and declining slightly at the very top. The share of capitalists increases sharply especially at the very top where 95% of the top 400 taxpayers fall into this category. This table shows clearly that top corporate executives at the beginning 21 At the very top, capitalists: investors and speculators form the overwhelming majority of our capitalists and rentiers group. 22 We have added a fractile for the top 0.001% (top 400 taxpayers in 1916) to emphasize how the very top is composed overwhelmingly of capitalists.
12 of the century were only a tiny minority within the top taxpayers. In contrast, in 1999, more than half of the very top taxpayers derive the major part of their income in the form of wages and salaries. Thus, today, the working rich celebrated by Forbes magazine have overtaken the coupon-clipping rentiers. The dramatic evolution of the composition of top incomes appears robust and independent from the erratic evolution of capital gains excluded in Figures I to IV. Tables A2 and A3 display the top income shares including realized capital gains. In Table A2, in order to get around the lumpiness of realizations, individuals are ranked by income excluding capital gains but capital gains are added back to income to compute shares. In Table A3, individuals are ranked by income including capital gains and capital gains are added back to income to compute shares. As depicted for the top 1% on Figure A2, these additional series show that including capital gains does not modify our main conclusion that very top income shares dropped enormously during the 1914-1945 period before increasing steadily in the last three decades. 23 The decline of the capital income share is a very long-term phenomenon and is not limited to a few years and a few thousands tax units. Figure V shows a gradual secular decline of the share of capital income (excluding again capital gains realizations) and dividends in the top 0.5 percent fractile from the 1920s to the 1990s: capital income made about 55 percent of total income in the 1920s, 35 percent in the 1950s-1960s, and 15 percent in the 1990s. Sharp declines occurred during World War I, the Great Depression, and World War II. Capital income recovered only partially from these shocks in the late 1940s and started a steady decline in the mid-1960s. This secular decline is entirely due to dividends: the share of interest, rent and royalties has been roughly flat while the dividend 23 It is interesting to note, however, that during the 1960s, when dividends were strongly tax disadvantaged relative to capital gains, capital gains do seem to represent a larger share in top incomes than during other periods such as the 1920s or late 1990s that also witnessed large increases in stock prices.
13 share has dropped from about 40 percent in the 1920s, to about 25 percent in the 1950s and 1960s, to less than 10 percent in the 1990s. 24 Most importantly, the secular decline of top capital incomes is due to a decreased concentration of capital income rather than a decline in the share of capital income in the economy as a whole. As displayed on Figure VI, the National Income Accounts series show that the aggregate capital income share has not declined over the century. As is well known, factor shares in the corporate sector have been fairly flat in the long-run with the labor share around 70-75 percent, and the capital share around 25-30 percent (Panel A). The share of capital income in aggregate personal income is about 20 percent both in the 1920s and in the 1990s (Panel B). Similarly, the share of dividends was around 5 percent in the late 1990s and only slightly higher (about 6-7 percent) before the Great Depression. This secular decline is very small compared to the enormous fall of top capital incomes. 25 Contrarily to a widely held view, dividends as a whole are still well and alive. 26 It should be noted, however, that the ratio of total dividends reported on individual tax returns to personal dividends in National Accounts has declined continuously over the period 1927 to 1995, starting from a level close to 90 percent in 1927, declining slowly to 60 percent in 1988, and dropping precipitously to less than 40 percent in 1995. This decline is due mostly to the growth of funded pension plans and retirement saving accounts through which individuals receive dividends that are never reported as dividends on income tax returns. For the highest income earners, this additional source of dividends is likely to be very small relative to dividends directly reported on tax returns. 24 Tax statistics by size of dividends analyzed in Piketty and Saez [2001] confirm a drastic decline of top dividend incomes over the century. In 1998 dollars, top 0.1 percent dividends earners reported on average about $500,000 of dividends in 1927 but less than $240,000 in 1995. 25 The share of dividends in personal income starts declining in 1940 because the corporate income tax increases sharply and permanently, reducing mechanically profits that can be distributed to stockholders. 26 As documented by Fama and French (2000), a growing fraction of firms never pay dividends (especially in the new technology industries, where firms often make no profit at all), but the point is that total dividend payments continue to grow at the same rate as aggregate corporate profits.
14 Estate tax returns statistics (available since the beginning on the estate tax in 1916) are an alternative important source of data to analyze the evolution of large fortunes. 27 Kopczuk and Saez (2004) used those data, recently compiled in electronic format by the IRS for most of the period, to construct top wealth shares for the period 1916-2000 using the estate multiplier method. Figure VII displays the top 0.1% share series from Kopczuk and Saez (2004). It shows that the top 0.1% has indeed dropped drastically from over 20% in the early part of the century to around 7.5% in the 1970s. In contrast to top income shares, the increase in wealth concentration has been modest since the 1970s: the top 0.1% wealth share has increased modestly to around 9-10% by 2000. This evidence is consistent with our previous results on the decline in top capital incomes over the century. There is a concern that estate tax avoidance and evasion might bias downward wealth concentration estimated using the estate multiplier technique. The most popular forms of estate tax avoidance involve setting up trusts whereby wealthy individuals can pass substantial wealth to the next generations with modest gift tax liability and while keeping some control over assets. Tax statistics on trusts, analyzed in Kopczuk and Saez (2004), show, however, that capital income earned through all trusts is relatively modest and has actually declined in relative terms over the century. Thus, adding back all trust wealth to top wealth holders would not affect the pattern of top wealth shares constructed in Kopczuk and Saez (2004). C. Proposed interpretation: the role of progressive taxation How can we explain the steep secular decline in capital income concentration? It is easy to understand how the macro-economic shocks of the Great Depression and the fiscal shocks of World War I and World War II have had a negative impact on capital concentration. The difficult question to answer is why large fortunes did not recover from these shocks. The most natural and realistic candidate for an explanation seems to be the creation and the 27 In particular, capital gains not realized before death are never reported on income tax returns, but are included in the value of assessed estates.
15 development of the progressive income tax (and of the progressive estate tax and corporate income tax). The very large fortunes that generated the top 0.01 percent incomes observed at the beginning of the century were accumulated during the nineteenth century, at a time where progressive taxes hardly existed and capitalists could dispose of almost all their income to consume and to accumulate. 28 The fiscal situation faced by capitalists in the twentieth century to recover from the shocks incurred during the 1914 to 1945 period has been substantially different. Top tax rates were very high from the end of World War I to the early 1920s, and then continuously from 1932 to the mid-1980s. Moreover, the United States has imposed a sharply progressive estate tax since 1916, and a substantial corporate income tax ever since World War II. 29 These very high marginal rates applied to only a very small fraction of taxpayers, but created a substantial burden on the very top income groups (such as the top 0.1 percent and 0.01 percent) composed primarily of capital income. In contrast to progressive labor income taxation, which simply produces a level effect on earnings through labor supply responses, progressive taxation of capital income has cumulative or dynamic effects because it reduces the net-return on wealth which generates tomorrow s wealth. It is difficult to prove in a rigorous way that the dynamic effects of progressive taxation on capital accumulation and pre-tax income inequality have the right quantitative magnitude and account for the observed facts. One would need to know more about the savings rates of capitalists, how their accumulation strategies have changed since 1945. The orders of magnitude do not seem unrealistic, especially if one assumes that the owners of large fortunes, whose pre-tax incomes were already severely hit by the prewar shocks, were not willing to reduce their consumption to very low levels. Piketty [2001, 2003] provides simple numerical simulations showing that for a fixed saving rate, introducing substantial capital income taxation has a tremendous effect on the time needed 28 During the nineteenth century, the only progressive tax was the property tax, but its level was low (see Brownlee [2000] for a detailed description). 29 From 1909 (first year the corporate tax was imposed) to the beginning of World War II, the corporate tax rate was low, except during World War I.
16 to reconstitute large wealth holdings after negative shocks. Moreover, reduced savings in response to a reduction in the after-tax rate of return on wealth would accelerate the decrease in wealth inequality. Piketty [2003] shows that in the classic dynastic model with infinite horizon, any positive capital income tax rate above a given high threshold of wealth will eventually eliminate all large wealth holdings without affecting, however, the total capital stock in the economy. We are not the first to propose progressive taxation as an explanation for the decrease in top shares of income and wealth. Lampman [1962] did as well and Kuznets [1955] explicitly mentioned this mechanism as well as the shocks incurred by capital owners during the 1913 to 1948 period, before presenting his inverted U-shaped curve theory based on technological change. Explanations pointing out that periods of technological revolutions such as the last part of the nineteenth century (industrial revolutions) or the end of the twentieth century (computer revolution) are more favorable to the making of fortunes than other periods might also be relevant. 30 Our results suggest that the decline in income tax progressivity since the 1980s, the reduction in the tax rate for dividend income in 2003, and the projected repeal of the estate tax by 2011 might produce again in a few decades levels of wealth concentration similar to those of the beginning of the twentieth century. 31 4. TOP WAGE SHARES Table B2 displays top wage shares from 1927 to 2002 constructed using IRS tabulations by size of wages. There are three caveats to note about these long-term wage inequality series. First, self-employment income is not included in wages and therefore our series focus only on wage income inequality. As self- 30 DeLong [1998] also points out the potential role of anti-trust law. According to DeLong, antitrust law was enforced more loosely before 1929 and since 1980 than between 1929 and 1980. 31 The tax cut on dividend income of 2003 generated a surge in dividend initiations among publicly traded companies (Chetty and Saez, 2004). Microsoft, for example, started paying dividends in 2003 and made a huge special dividend distribution in 2004. William Gates, founder of the company and richest American person, will earn $3,600 million of dollars from Microsoft dividends in 2004, by far the largest income ever earned in any single year in the United States. It
17 employment income has been a decreasing share of labor income over the century, it is conceivable that the pool of wage and salary earners has substantially evolved overtime, and that total labor income inequality series would differ from our wage inequality series. Second and related, large changes in the wage force due to the business cycle and wars might affect our series through compositional effects because we define the top fractiles relative to the total number of tax units with positive wage income. As can be seen in column (1) of Table B1, the number of tax units with wages declined during the Great Depression due to high levels of unemployment, increased sharply during World War II because of the increase in military personnel, and decreased just after the war. We show in appendix B3 that these entry effects do not affect top shares when the average wage of the new entrants is equal to about 50 percent of the average wage. This condition is approximately satisfied for military personnel in World War II and thus top wage shares including or excluding military personnel during World War II are almost identical. Third, our wage income series are based on the tax unit and not the individual. As a result, an increase in the correlation of earnings across spouses, as documented in Karoly [1993], with no change in individual wage inequality, would generate an increase in tax unit wage inequality. 32 Figure VIII displays the wage share of the top decile and Figure IX displays the wage shares of the P90-95, P95-99, and P99-100 groups from 1927 to 2002. As for overall income, the pattern of top decile wage share over the century is also U-shaped. There are, however, important differences that we describe below. It is useful to divide the period from 1927 to 2002 into three subperiods: the pre-world War II period (1927 to 1940), the war and post-war period remains to be seen whether this reform will affect significantly the composition of top reported incomes. It will certainly be a useful test of the magnitude of fiscal manipulation effects. 32 This point can be analyzed using the Current Population Surveys available since 1962 which allow the estimation of wage inequality series both at the individual and tax unit level. In Canada, it is possible to construct top income shares both at the family and individual level since 1982. Those series, presented in Saez and Veall (2004) show that the upward trend in top income shares is almost identical at the individual and family suggesting that the secondary earner effect cannot explain the surge in top income shares.
18 (1941 to 1969), and the last three decades (1970 to 2002). We analyse each of these periods in turn. A. Wage inequality stability before World War II Top wage shares display a striking stability from 1927 to 1940. This is especially true for the top percentile. In contrast to capital income, the Great Depression did not produce a reduction in top wage shares. On the contrary, the high middle class fractiles benefited in relative terms from the Great Depression. Even though the IRS has not published tables on wage income over the period 1913 to 1926, we can use an indirect source of evidence to document trends in top wage shares. Corporation tax returns require each corporation to report separately the sum of salaries paid to its officers. This statistic, compensation of officers, is reported quasi-annually by the IRS starting in 1917. We report in Figure X the total compensation of officers reported on corporate tax returns divided by the total wage bill in the economy from 1917 to 1960 along with the shares of the P99.5-100 and P99-99.9 wage groups which are close in level to the share of officer compensation. From 1927 to 1960, officer compensation share and these fractiles shares track each other relatively closely. Therefore, the share of officer compensation from 1917 to 1927 should be a good proxy as well for these top wage shares. This indirect evidence suggests that the top share of wages was also roughly constant, or even slightly increasing from 1917 to 1926. Previous studies have suggested that wage inequality has been gradually decreasing during the first half of the twentieth century (and in particular during the inter-war period) using series of wage ratios between skilled and unskilled occupations (see e.g., Keat [1960], Williamson and Lindert [1980]). However, it is important to recognize that a decrease in the ratio of skilled over unskilled wages does not necessarily imply an overall compression of wage income inequality, let alone a reduction in the top wage shares. Given the continuous rise in the numerical importance of white collar jobs, it is natural to expect that the ratios of
19 high-skill wages to low-skill wages would decline over time, even if wage inequality measured in terms of shares of top fractiles of the complete wage distribution does not change. 33 Goldin and Katz [1999] have recently presented new series of white-collar to blue-collar earnings ratios from the beginning of the twentieth century to 1960, and they find that the decrease in pay ratio is concentrated only in the short periods of the two World Wars. Whether or not the compression of wages that occurred during World War I was fully reversed during the 1920s in the United States is still an open question. 34 B. Sharp drop in inequality during World War II with no recovery In all of our wage shares series, there is a sharp drop during World War II from 1941 to 1945. 35 The higher the fractile, the greater is the decrease. The share of P90-95 declines by 16 percent between 1940 and 1945, but the share of the top 1 percent declines by more than 30 percent, and the top 0.1 percent by almost 35 percent during the same period (Table B2). This sharp compression of high wages can fairly easily be explained by the wage controls of the war economy. The National War Labor Board, established in January 1942 and dissolved in 1945, was responsible for approving all wage changes and made any wage increase illegal without its approval. Exceptions to controls were more frequently granted to employees receiving low wages. 36 Lewellen [1968] has studied the evolution of executive compensation from 1940 to 1963 and his results show 33 For instance, Piketty [2001] reports a long-run compression (both from 1900 to 1950 and from 1950 to 1998) of the ratio of the average wage of managers over the average wage of production workers in France, even though wage inequality (measured both in terms of top fractiles wage shares and in terms of P90/P10-type ratios) was constant in the long run. 34 Tax return data available for France make it possible to compute wage inequality series starting in 1913 (as opposed to 1927 in the United States). By using these data, Piketty [2001, 2003] found that wage inequality in France (measured both in terms of top wage shares and in terms of P90/P10 ratios) declined during World War I but fully recovered during the 1920s, so that overall wage inequality in 1930 or 1940 was the same as in 1913. Another advantage of the French wage data is that it always based upon individual wages (as opposed to total tax unit wages in the United States). 35 Note that for fractiles below the top percentile, the drop starts from 1940 to 1941. 36 See Goldin and Margo [1992] for a more detailed description.
20 strikingly that executive salaries were frozen in nominal terms from 1941 to 1945 consistent with the sharp drop in top wage shares that we find. The surprising fact, however, is that top wage shares did not recover after the war. A partial and short-lived recovery can be seen for all groups, except the very top. But the shares never recover more than one third of the loss incurred during World War II. Moreover, after a short period of stability in the late 1940s, a second phase of compression takes place in the top percentile. This compression phase is longer and most pronounced the higher the fractile. While the fractiles P90-95 and P95-99 hardly suffer from a second compression phase and start recovering just after the war, the top groups shares experience a substantial loss from 1950 to the mid-1960s. The top 0.1 percent share for example declines from 1.6 percent in 1950 to 1.1 percent in 1964 (Table B2). The overall drop in top wage shares, although important, is significantly lower than the overall drop in top income shares. The top 1 percent income share dropped from about 18-19 percent before World War I and in the late 1920s to about 8 percent in the late 1950s (Figure II), while the top 1 percent wage share dropped from about 8.5 percent in the 1920s to about 5 percent in the late 1950s (Figure IX). This confirms that capital income played a key role in the decline of top income shares during the first half of the century. C. The increase in top shares since the 1970s Many studies have documented the increase in inequality in the United States since the 1970s (see e.g., Katz and Murphy [1992]). Our evidence on top shares is consistent with this evidence. After the World War II compression, the fractiles P90-95 and P95-99 recovered slowly and continuously from the 1950s to the 1990s, and reached the pre-world War II level in the beginning of the 1980s. As described above, the recovery process for groups within the top percentile did not begin until the 1970s and was much faster. In accordance with results obtained from the March Current Population Surveys [Katz and Murphy, 1992, Katz and Autor, 1999], we find that wage inequality, measured by top fractile wage shares, starts to increase in the early 1970s. This is in contrast with results
21 from the May Current Population Surveys [DiNardo et al. 1996] suggesting that the surge in wage inequality is limited to the 1980s. From 1970 to 1984, the top 1 percent share increased steadily from 5 percent to 7.5 percent (Figure IX). From 1986 to 1988, the top shares of wage earners increased sharply, especially at the very top (for example, the top 1 percent share jumps from 7.5 percent to 9.5 percent). This sharp increase was documented by Feenberg and Poterba [1993] and is certainly attributable at least in part to fiscal manipulation following the large top marginal tax rate cuts of the Tax Reform Act of 1986 (see the discussion in Section III above). However, from 1988 to 1994, top wage shares stay on average constant, 37 but increase very sharply from 1994 to 2000 (the top 1 percent wage share increases from 8.7 percent to 12.6 percent). While everybody acknowledges that tax reforms can have large short-term effects on reported incomes due to retiming, there is a controversial debate on whether changing tax rates can have permanent effects on the level of reported incomes. Looking at long-time series up to 2001 casts doubts on the supply-side interpretation that tax cuts can have lasting effects on reported wages. Part of the recent increase in top wages is due to the development of stock-options that are reported as wages and salaries on tax returns when they are exercised. Stock-options are compensation for labor services but the fact that they are exercised in a lumpy way may introduce some upward bias in our annual shares at the very top (top 0.1 percent and above). To cast additional light on this issue and on the timing of the top wage surge, we look at CEO compensation from 1970 to 2003 using the annual surveys published by Forbes magazine since 1971. These data provide the levels and composition of compensation for CEOs in the 800 largest publicly traded US corporations. Figure XI displays the average real compensation level (including stock-option exercised) for the top 100 CEOs from the Forbes list, along with the compensation of the CEO ranked 100 in the list, and the salary plus bonus level 37 One can note the surge in high wages in 1992 and the dip in 1993 and 1994 due to retiming of labor compensation in order to escape the higher rates enacted in 1993 (see Goolsbee [2000]).